Conflicts of interest – don't bolt for the door

Boards are very sensitive – and rightly so – to any perception of material conflicts of interest.

But good management does not mean defaulting immediately to a “cut and run” response where directors resign or absent themselves from decision-making.

Bolting for the door

There is obvious comfort and safety in a highly conservative response, especially given the legal exposure associated with being a director. But the director’s first responsibility is to maximise shareholder value by bringing his or her skills and insights into boardroom decision-making – and to do that, you need to be at the table.

A very serious and material conflict may well require an information barrier or similar to be put around a director, or for a director to step away from certain decisions. But this option should always be counterbalanced against the downside of depriving the board of that director’s perspective.

The ultimate objective should be to achieve a balance between protecting a director and the company from the risk that decision-making is influenced by an actual (or perceived) conflict while also maintaining access to the board’s full complement of governance skills in the evaluation of key business opportunities.

A more pragmatic approach

The temptation may be to ring-fence those board members from strategy development altogether. But a more thoughtful and pragmatic approach may be advisable – particularly if kept under continuous review and ratcheted up as and when required.

This might entail:

noting at the outset that conflict issues may emerge

agreeing to monitor the risk and take advice as necessary, and

giving each director the opportunity to identify any conflicts as they arise and to absent him or herself from specific discussions as appropriate.

A nuanced position from the Federal Court of Australia

A recent judgment[1] from the Federal Court of Australia illustrates that the purpose of conflict rules is to safeguard the outcomes being achieved for the company and its shareholders – and that other interests per se will not always be a drag on shareholder value.

The case concerned a longstanding cross shareholding between two large, publicly listed companies – a brick works and a pharmaceutical company. They entered the arrangement partly as a mechanism to prevent external take-over but also so that they could each diversify from their core business and because they shared a like-minded long-term perspective.

Both were each other’s biggest shareholder and both were heavily represented on each other’s board, and voting patterns reflected this, particularly on matters relating to the future of the cross shareholding.

Perpetual Investment Management Ltd – an institutional investor with a stake in each company – had been pressing for years to have the cross shareholding unwound on the basis that it was “unfair” and “oppressive” because it worked to entrench control by the incumbent boards.

The Court ultimately took a benign view of the potential conflicts, noting that although it could give rise to actual and perceived conflicts of interest, in practice the boards had both been performing well.

Specifically, the Court commented:

“To date, there is no suggestion that either board has under-performed and, to the contrary, the consensus appears to be that both boards have performed well and both companies are well managed, lending weight to the perception that the cross shareholding, to date, has facilitated stability and a capacity for long-term decision-making” and

“There was good reason to infer that the directors of each company had, and would in future, diligently consider the structure of the companies with their obligations to act in the best interests of the company firmly in mind”.

It is easy to imagine a New Zealand court coming to the same conclusion.

Legal requirements engaged in a conflict of interest

The specific legal requirements that might be engaged in a conflict of interest are:

Disclosure of interests

The Companies Act 1993 requires that directors disclose any interest they may have “forthwith after becoming aware of the fact”. A director can be “interested” even if he or she is not positioned to derive a material financial benefit from the proposed decision.

The new NZX Corporate Governance Code recommends that the issuer’s Code of Ethics should require directors (and employees) to declare conflicts of interest at the first opportunity and to proactively advise of any potential conflicts.

Voting restrictions

The Companies Act does not prohibit directors from voting on matters in which they may be interested, but restrictions to this effect can be imposed through the constitution.

The Listing Rules state that interested directors cannot vote unless the matter is one in respect of which the Companies Act requires a certificate to be signed (e.g. a dividend) or is an indemnities resolution.

Use of company information

Directors holding multiple directorships must be careful that they do not apply information obtained in one directorship capacity to decisions made in another directorship capacity.

Director independence

A director is deemed to have a ‘disqualifying relationship’ in the NZX Listing Rules where that person or an associate is a substantial shareholder in the issuer or has a relationship with the issuer outside that of being a director and is likely to derive a substantial portion of his or her income from the issuer (generally 10% or more, excluding dividends and other distributions payable to all shareholders).

Conclusion

Conflicts of interest are not easy to manage and generally involve an element of subjective judgement, which can make boards (and their legal advisers) reach for the safest solution.

But taking fright at the first scent of risk, although it may seem the safest strategy, isn’t always the best – not when it is an over-reaction and reduces the skill set available to the board when it is evaluating an important transaction or business direction.

A more sophisticated and nuanced calculation is needed – one which puts the shareholders’ interests and the company’s long-term prospects front and centre.